Trampling the Caution Flag

Gross domestic product contracted in the fourth quarter, making it the first negative quarter of growth since the second quarter of 2009. The bad news is in stunning stark contrast with a stock market that appears complacent and without concerns.

Fourth-quarter weakness was more or less across the board, with declining output seen in three out of four components of GDP. Only a small gain in personal consumption expenditures kept the contraction from being sharper than it was.

The biggest drag came from large cutbacks in government spending, both in the defense and non-defense sectors, however, business investment also declined and the subtraction from a higher trade deficit also had an effect.

It was already evident early in the fourth quarter that defense contractors had been prepping for the fiscal cliff. Contracts were being cancelled and there was some shelving of capital investment. Even though the fiscal cliff has been dealt with and we have a reprieve from the constraints of the debt ceiling, at least until May 18, the prospect of the sequester is becoming more real and both Republicans and Democrats appear comfortable with the fact that these automatic spending cuts are going to kick in as expected on March 1.

Added to this mix, the payroll tax increase that took place on January 1 may already be starting to bite, as we've seen some indication in consumer confidence, via the Conference Board's monthly survey, that the animal spirits are starting to cool. Consumer confidence, as measured by its index, dropped to the lowest level in 13 months in January.

These observations come against a backdrop of rising stock prices that, as previously mentioned, display an almost giddy attitude. Take for example the American Association of Individual Investors' weekly survey, which shows bearish sentiment to be the lowest in nearly a year and bullish readings at the highest level in two years.

And if that isn't enough to wave a caution flag, some famed hedge fund managers who haven't necessarily been all that bullish of late are suddenly expressing unbridled bullishness while forecasting an explosion of greatness is about to hit the U.S. Oh, really? Seems like odd timing, particularly given the fact that America is about to embark on its own path of deep austerity the likes of which we have seen in Europe over the past three years, which has brought some very disturbing results.

Despite all this, the Dow Jones Industrial Average is within easy striking distance of its all-time high of 14,164.53 and, clearly, this would not be the first time that the stock market was carried to new heights on a tsunami of rising bullish sentiment, even as underlying fundamental conditions erode. For now, I expect the uptrend to continue as the bulls pile on, but a fair-sized correction seems not too far off.